Members of an LLC and Partners of a Partnership Are Not Employees

In a recent treasury decision (TD 9766, NPRM REG-114307-15) the IRS has issued final, temporary and proposed regs that preserve a partner’s status as a partner, and not an employee. In this decision, the partner worked for a disregarded entity that was also owned by the partnership. The regulations settled herein are said to be consistent with Rev. Rul. 69-184, which concluded that members of a partnership are not employees of the partnership, even if they devote time to the partnership’s trade or business or provide services to the partnership as an independent contractor. 

The government, however, correctly noted in its discussions that it still needs a significant amount of outside assistance (particularly in the employee benefits area) to get comfortable with any such exception to the ‘partner-only’ treatment of persons who hold an equity interest (no matter how small) in a tax partnership and who also provide services to such partnership."  For example, it seems, certain members who hold say very small (incentive) amounts of an interest in the entity and who actually provides services to the entity might actually be considered as employees.  However, those situations are rare (see also Rev Ruling 69-184).

Treatment of Disregarded Entities (one-member LLCs) and Partners

An entity, such as a limited liability company, with a single owner is treated as a DE (assuming the entity did not elect to be treated as a corporation). Ordinarily, the DE is disregarded as an entity separate from its owner and is treated like a sole proprietorship, with the DE’s income and deductions attributed to the owner. However, for employment tax purposes, the IRS amended its regs previously so that a DE is treated as a corporation and is considered to be the employer of its employees. The owner of the DE is not treated as the employer.

At the same time, the owner of the DE is treated as self-employed and must pay self-employment tax on the DE’s earnings. Thus, for the owner’s self-employment purposes, the entity continues to be disregarded from the owner.

There is no distinction between a DE owned by an individual and a DE owned by a partnership. In fact, the current regulations do not discuss a DE that is owned by a partnership. Because a DE is treated as the employer of its employees, some partners have interpreted the current regs to permit individual partners to be treated as employees, if the partners provide services to a DE, even a DE owned by the partnership. Under this interpretation, partners have been treated as employees of the DE and have been allowed to participate in the partnership’s employee benefit plans.  This interpretation was not intended, the IRS indicated. There is no exception in the self-employment rules for a partnership that owns a DE. The IRS also affirmed that the regulations do not alter Revenue Ruling 69-184, which requires that partners providing services be treated as self-employed.

The New Regulations

The temporary regulations "clarify" that the rule treating a DE as a corporation for employment tax purposes does not apply to the employment tax treatment of individuals who are partners of a partnership that owns a DE. The entity continues to be disregarded from the partners for self-employment tax purposes, and the partners are still subject to self-employment tax as partners of a partnership. The partners are treated no differently from partners of a partnership that does not own a DE.

The regulations will not apply until the later of (1) August 1, 2016, or (2) or the first day of the latest-starting plan year after May 4, 2016, for an "affected" plan sponsored by a DE. Affected plans include qualified plans, health plans, and cafeteria plans. This effective date gives partnerships time to make payroll and benefit plan adjustments.

Finally Regarding Rev. Rul. 69-184

The regs do not address Rev. Rul. 69-184 and tiered partnerships. The IRS reported that stakeholders have requested guidance in this situation and, also, where employees of a partnership receive a small partnership interest as compensation. The IRS requested comments on the appropriate application of Rev. Rul. 69-184 in these situations, including when it would be appropriate to treat partners as employees, and the impact on employee benefit plans and on employment taxes.

 

References: CCH FED Paragraphs 47,024 and 49,696.